CAPITAL

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Capital, in the most basic terms, is money. All businesses must have
capital in order to purchase assets and maintain their operations.
Business capital comes in two main forms: debt and equity. Debt refers to
loans and other types of credit that must be repaid in the future, usually
with interest. In contrast, equity generally does not involve a direct
obligation to repay the funds. Instead, equity investors receive an
ownership position which usually takes the form of stock in the company.

The capital formation process describes the various means through which
capital is transferred from people who save money to businesses that
require funds. Such transfers may take place directly, meaning that a
business sells its stocks or bonds directly to savers who provide the
business with capital in exchange. Transfers of capital may also take
place indirectly through an investment banking house or through a
financial intermediary, such as a bank, mutual fund, or insurance company.
In the case of an indirect transfer using an investment bank, the business
sells securities to the bank, which in turn sells them to savers. In other
words, the capital simply flows through the investment bank. In the case
of an indirect transfer using a financial intermediary, however, a new
form of capital is actually created. The intermediary bank or mutual fund
receives capital from savers and issues its own securities in exchange.
Then the intermediary uses the capital to purchase stocks or bonds from
businesses.

THE COST OF CAPITAL

"Capital is a necessary factor of production and, like any other
factor, it has a cost," according to Eugene F. Brigham in his book
Fundamentals of Financial Management.
In the case of debt capital, the cost is the interest rate that the firm
must pay in order to borrow funds. For equity capital, the cost is the
returns that must be paid to investors in the form of dividends and
capital gains. Since the amount of capital available is often limited, it
is allocated among various businesses on the basis of price. "Firms
with the most profitable investment opportunities are willing and able to
pay the most for capital, so they tend to attract it away from inefficient
firms or from those whose products are not in demand," Brigham
explained. But "the federal government has agencies which help
individuals or groups, as stipulated by Congress, to obtain credit on
favorable terms. Among those eligible for this kind of assistance are
small businesses, certain minorities, and firms willing to build plants in
areas with high unemployment."

As a rule, the cost of capital for small businesses tends to be higher
than it is for large, established businesses. Given the higher risk
involved, both debt and equity providers charge a higher price for their
funds. "A number of researchers have observed that portfolios of
small-firm stocks have earned consistently higher average returns than
those of large-firm stocks; this is called the 'small-firm
effect,' " Brigham wrote. "In reality, it is bad news
for the small firm; what the small-firm effect means is that the capital
market demands higher returns on stocks of small firms than on otherwise
similar stocks of large firms. Therefore, the cost of equity capital is
higher for small firms." The cost of capital for a company is
"a weighted average of the returns that investors expect from the
various debt and equity securities issued by the firm," according
to Richard A. Brealey and Stewart C. Myers in their book
Principles of Corporate Finance.

CAPITAL STRUCTURE

Since capital is expensive for small businesses, it is particularly
important for small business owners to determine a target capital
structure for their firms. The capital structure concerns the proportion
of capital that is obtained through debt and equity. There are tradeoffs
involved: using debt capital increases the risk associated with the
firm's earnings, which tends to decrease the firm's stock
prices. At the same time, however, debt can lead to a higher expected rate
of return, which tends to increase a firm's stock price. As Brigham
explained, "The optimal capital structure is the one that strikes a
balance between risk and return and thereby maximizes the price of the
stock and simultaneously minimizes the cost of capital."

Capital structure decisions depend upon several factors. One is the
firm's business risk—the risk pertaining to the line of
business in which the company is involved. Firms in risky industries, such
as high technology, have lower optimal debt levels than other firms.
Another factor in determining capital structure involves a firm's
tax position. Since the interest paid on debt is tax deductible, using
debt tends to be more advantageous for companies that are subject to a
high tax rate and are not able to shelter much of their income from
taxation.

A third important factor is a firm's financial flexibility, or its
ability to raise capital under less than ideal conditions. Companies that
are able to maintain a strong balance sheet will generally be able to
obtain funds under more reasonable terms than other companies during an
economic downturn. Brigham recommended that all firms maintain a reserve
borrowing capacity to protect themselves for the future. In general,
companies that tend to have stable sales levels, assets that make good
collateral for loans, and a high
growth rate can use debt more heavily than other companies. On the other
hand, companies that have conservative management, high profitability, or
poor credit ratings may wish to rely on equity capital instead.

SOURCES OF CAPITAL

DEBT CAPITAL
Small businesses can obtain debt capital from a number of different
sources. These sources can be broken down into two general categories,
private and public sources. Private sources of debt financing, according
to W. Keith Schilit in
The Entrepreneur's Guide to Preparing a Winning Business Plan and
Raising Venture Capital,
include friends and relatives, banks, credit unions, consumer finance
companies, commercial finance companies, trade credit, insurance
companies, factor companies, and leasing companies. Public sources of debt
financing include a number of loan programs provided by the state and
federal governments to support small businesses.

There are many types of debt financing available to small
businesses—including private placement of bonds, convertible
debentures, industrial development bonds, and leveraged buyouts—but
by far the most common type of debt financing is a regular loan. Loans can
be classified as long-term (with a maturity longer than one year),
short-term (with a maturity shorter than two years), or a credit line (for
more immediate borrowing needs). They can be endorsed by co-signers,
guaranteed by the government, or secured by collateral—such as real
estate, accounts receivable, inventory, savings, life insurance, stocks
and bonds, or the item purchased with the loan.

When evaluating a small business for a loan, Jennifer Lindsey wrote in her
book
The Entrepreneur's Guide to Capital,
lenders ideally like to see a two-year operating history, a stable
management group, a desirable niche in the industry, a growth in market
share, a strong cash flow, and an ability to obtain short-term financing
from other sources as a supplement to the loan. Most lenders will require
a small business owner to prepare a loan proposal or complete a loan
application. The lender will then evaluate the request by considering a
variety of factors. For example, the lender will examine the small
business's credit rating and look for evidence of its ability to
repay the loan, in the form of past earnings or income projections. The
lender will also inquire into the amount of equity in the business, as
well as whether management has sufficient experience and competence to run
the business effectively. Finally, the lender will try to ascertain
whether the small business can provide a reasonable amount of collateral
to secure the loan.

EQUITY CAPITAL
Equity capital for small businesses is also available from a wide variety
of sources. Some possible sources of equity financing include the
entrepreneur's friends and family, private investors (from the
family physician to groups of local business owners to wealthy
entrepreneurs known as "angels"), employees, customers and
suppliers, former employers, venture capital firms, investment banking
firms, insurance companies, large corporations, and government-backed
Small Business Investment Corporations (SBICs).

There are two primary methods that small businesses use to obtain equity
financing: the private placement of stock with investors or venture
capital firms; and public stock offerings. Private placement is simpler
and more common for young companies or startup firms. Although the private
placement of stock still involves compliance with several federal and
state securities laws, it does not require formal registration with
Securities and Exchange Commission. The main requirements for private
placement of stock are that the company cannot advertise the offering and
must make the transaction directly with the purchaser.

In contrast, public stock offerings entail a lengthy and expensive
registration process. In fact, the costs associated with a public stock
offering can account for more than 20 percent of the amount of capital
raised. As a result, public stock offerings are generally a better option
for mature companies than for startup firms. Public stock offerings may
offer advantages in terms of maintaining control of a small business,
however, by spreading ownership over a diverse group of investors rather
than concentrating it in the hands of a venture capital firm.